Trading Strategy: Trend line break (Introduction)

Jan 06, 3:06 pm

Trend lines, rising and falling lines are one of the simplest ways for traders to trade based on price action. However, there is often a lot of confusion in regards to how to plot the trend lines and where exactly, or at which point does one get into the trade. The Trend line break trading strategy offers traders, insights with minimal subjectivity involved while at the same time presenting a simplistic price action based trading strategy.

What are trend lines?

Trend lines are angled lines and represent dynamic support and resistance levels. They come in two forms:

  • Rising trend lines
  • Falling trend lines

A rising trend line is often formed by connecting the lows (or lower closing prices). Therefore, a rising trend line often constitutes a rising support line. When a rising trend line is broken, it represents that prices will decline in the short term (also referred to as a correction).

A falling trend line is formed by connecting the highs (or higher closing prices) and represents a dynamic resistance levels. When a falling trend line is broken, prices are expected to rally.

The chart below shows an example of a rising and a falling trend line respectively as well as the price action that follows after the trend line was broken.

Trend line

 

 

 

trendlines2

 

Why do trend lines work?

Trend lines work for the mere reason that price never travels in a straight up or straight down fashion, but rather moves in a series of up and down waves. The trend lines work incredibly well, when the correct wave is identified and when the trend line is broken by price; it signifies a correction to the previous move or leg.

How to plot trend lines?

In order to trade with trend lines, traders need to first understand the right way of plotting trend lines. While there is a lot of debate whether to use the highs and lows or closing prices, a logical conclusion is that one should always use the closing prices for connecting trend lines. This is because the closing prices are often given more weight and reflect trader activity rather than the highs and lows, which are mere rejections of the price movements. In order to plot trend lines correct, first switch your charts to the line chart (closing line chart) and then connect the peaks (higher closes) or troughs (lower closes) with at least two contact points. Once the trend line is plotted, you can then switch back to candlestick charts.

A major benefit of using the closing line chart instead of connecting highs or lows is that closing line chart is often noise free and simply shows the price action via the closing prices. The chart below shows an example of how the trend lines are to be plotted and the differences that we can easily see.

trendlines3

 

 

 

trendlines4

 

Comparing the above two methods, firstly plotting trend lines connecting the lower lows on the line chart removes quite a bit of subjectivity involved. In comparison, the candlestick chart with its highs and lows makes it a bit more complex in trying to identify the right lows to connect the rising trend line too.

It is therefore, essential to note that at least for beginners, it is a good practice to first plot a trend line on the line chart and later change to a candlestick chart.

Now that we know how to plot trend lines, in the next part we will deal with the trade aspects of the trend line strategy.

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